The
relationship between employers and employees has changed sharply over the past
few decades. One aspect of this change has been giving employees greater
responsibility and greater control over many aspects of their work life. This
shift is, perhaps, most notable in the area of retirement plans. These plans
have shifted from defined-benefit pension plans, where employees have few
decisions to make and have also face few risks, to defined-contribution plans
and others like it, where employees have to make investment decisions that are
associated with considerable risk.

The
idea that employees should make their own decisions does not suggest that
employers aren't concerned about employees making mistakes, of course. How much
help we should give employees in making those decisions is a tricky topic, as
everyone in the benefits business knows, because employers face legal risks
when providing what can be seen as financial advice.

Helping
employees understand how to think about these choices is another matter,
however. My colleague, Olivia Mitchell and Annamaria Lusardi, reviewed what we
know about the financial literacy of the population, understanding the basic
concepts that allow one to make sensible financial decisions. And the results are not pretty.

The
three concepts that seem to matter most are: understanding inflation, compound
interest and the reduction in risk associated with portfolios. These may sound
complicated, but what we mean here is simply understanding the basic ideas. Here
are the questions used to assess that knowledge among a random sample of
residents of the United States over age 50; those for whom these retirement
investment decisions really matter:

1:
Suppose you had $100 in a savings account and the interest rate was 2 percent
per year. After five years, how much do you think you would have in the account
if you left the money to grow: [more than $102, exactly $102, less than $102?]

2:
Imagine that the interest rate on your savings account was 1 percent per year
and inflation was 2 percent per year. After one year, would you be able to buy:
[more than, exactly the same as, or less than today with the money in this
account?]

3:
Do you think that the following statement is true or false? 'Buying a single company
stock usually provides a safer return than a stock mutual fund.'

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It is
easy to see why these concepts matter in practice. If one doesn't understand
inflation, it may make sense to park your investments in a low-yield savings
account, but then watch inflation eat away their value. Or, put all your
investments in a single company's stock, risking your financial ruin if that
company fails. Or, "roll" loans - i.e. delay payments -- while
compounding interest rates and penalties make it difficult to ever repay them.
Not surprisingly, extensive research finds that people with a poor
understanding of concepts like these have much worse financial outcomes. They
are also more likely to be caught up in scams.

Only
half of the respondents got the first question right; guessing would give you
the correct answer a third of the time. Only one in three got all of the
questions right. Other studies also show that women do worse on financial-literacy
tests like these than do men, and the really bad news may be the fact that
older individuals, who need this kind of understanding the most, are worse at
it than their younger colleagues. Yet, they are even more overconfident about
their financial literacy than those who are younger. Given what we know about
psychology, this overconfidence may not be surprising: We fool ourselves into
being overconfident about things that are threatening to us, as a way to stave
off worry. So the people who need help the most may be the least likely to seek
it.

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The
employers most likely to worry about their employees on these matters also
probably have employees who are better informed and are less in need of help in
understanding these basic financial concepts.

But
these results remind us of a few things. First, the people who need help the
most may be the least likely to ask for it. Simply offering help to those who
request it may not do all that much good. Second, there are real consequences
-- all bad -- for people who do not understand the most basic concepts
associated with investing. Third, as with most things in life, the biggest
gains come from getting the most basic knowledge. It does not take very much
information to be a lot better off. Nor does it take much time or effort to
teach employees the three concepts cited above.

Peter Cappelli is the George W. Taylor
Professor of Management and director of the Center for Human Resources at The
Wharton School. His latest book is Why Good
People Can't Get Jobs: The Skills Gap and What Companies Can Do About It.